This article appeared in the October 2011 ASX Investor Update
email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Learn about the dangers of holding too much cash in Self-Managed Super Funds.

By Robin Bowerman, Vanguard

Self-managed super funds (SMSFs) across Australia are manning the defensive portfolio parapets and their weapon of choice is cash. And this increase in cash holdings may be revealing considerably more than a simple lack of confidence in where the sharemarket is heading in the short term.

A recent research study by Vanguard/Investment Trends looking at the SMSF sector has shown that the so-called "wall of cash" in SMSFs has grown markedly as wary investors say they are waiting for the return of more favourable market conditions before reallocating funds to growth assets.

This may not be surprising but it is potentially a cause for concern if investors are trying to time markets rather than staying on course with a long-term asset allocation plan.

The nationwide survey of more than 3000 SMSF trustees shows that total cash and cash products held by SMSFs in Australia has grown by $40 billion since May 2009 to $113 billion in May 2011.

That is a dramatic increase in the headline numbers but the survey also identified the level of "excess cash" held by SMSFs - defined as funds that would normally have been invested in other investments/assets.

It is interesting that while overall cash holdings jumped significantly over the past couple of years, excess cash holdings have remained stable in terms of value at $39 billion, but now represents 35 per cent of SMSFs' total cash holdings, down from 53 per cent in May 2009.

The research is suggesting that the role of cash within SMSF portfolios is undergoing a change in status, from parking place to permanent fixture.

The implications of this excess cash declining and overall cash levels rising may be that what investors once considered the "waiting to invest" portion of their portfolio has now been re-categorised to form part of the broader fixed-interest asset allocation. (Editor’s note: Do the ASX online interest rate securities course to learn more about the features, benefits and risks of fixed-interest products.)

That raises the bigger question of what is the role of fixed interest within a portfolio?

Potential risks

A larger cash allocation may appear an attractive option at the moment with bank term deposits providing rates of around 6 per cent per annum. US and European investors would look at those rates with envy.

However, over the long term, investors need to feel confident that their asset allocation is aligned to their risk/return profile and also their time horizon. Investors also need to understand the potential risks involved in having a portfolio that is overweight in cash.

Fixed interest is crucial to a well-diversified portfolio. In addition to providing regular income, it acts as a counterbalance to the inherent volatility of growth assets and also helps moderate a portfolio's downside risk. The fixed-interest asset class also provides capital stability and lowers the variability of portfolio returns.

While these characteristics may sound a lot like term deposits, comparing the two side by side reveals some key differences, in particular, time and liquidity.

Beyond their initial similarities of regular income flow and limiting capital growth or loss, differences start to appear when we examine risk versus return. Cash has a low risk/return profile but is inherently short-term, at six to 12 months, whereas fixed interest offers a more medium risk/return profile with a typical investment horizon being three to five years.

An investor's risk/return decision is heavily influenced by their time horizon. Cash in a term deposit usually requires a minimum timeframe of three, six or 12 months; fixed interest or bonds are more suited to those with at least a three-year outlook. So although a higher cash allocation may be appropriate for a retiree to cover a year or two of living expenses, for an investor with a decade or more to go to retirement, a broader exposure to fixed interest may be more appropriate.

Fixed-interest investing is also a lot broader than cash or term deposits and can span a wider risk spectrum. It could consist of highly defensive assets such as Australian or US government bonds, expand further to include semi-government bonds and supranational borrowers (i.e. The World Bank) or, moving along the credit risk curve, incorporate high-quality corporate bonds (think Toyota and BHP) all the way out to high-yielding so-called junk bonds.

The key point is that fixed-interest investing is broad; indeed, the fixed-interest markets globally are larger and more liquid than global sharemarkets. But in Australia our fixed-interest marketplace is relatively small, less visible and less understood - perhaps a positive, albeit unintended, consequence of having a Federal Government running budget surpluses for many years.

Indeed, one of the reasons SMSFs are retreating to term deposits as a quasi fixed-interest portfolio allocation - apart from the attractive short-term rates - is the lack of awareness and ability to access broader fixed-interest investments such as government bonds. Managed funds do offer broad fixed-interest products but they have not seen strong take-up among SMSFs.

SMSFs are often more likely to access investments directly. And while the Australian exchange-traded funds (ETFs) market in shares is growing strongly, fixed-interest ETFs are not yet able to be offered under the existing regulatory framework.

Benchmark portfolio

The asset allocation decision is most important for investors when it comes to their portfolio's risk-and-return profile.

For anyone running their own SMSF, having a benchmark portfolio to measure yourself against can be a valuable, dispassionate tool. The Vanguard diversified funds are all index funds so they reflect market returns over the past eight years.

The portfolios range from conservative to high growth. In the conservative portfolio the cash allocation is 42 per cent while Australian and international fixed interest holdings are 11 per cent and 17 per cent respectively, giving a total allocation to income assets of 70 per cent. By contrast, the balanced portfolio has 50 per cent in cash and fixed interest, and 50 per cent in growth assets.

Another key consideration for someone running their own SMSF is the need to rebalance the portfolio. Periods of volatility can change the allocations, so it is important to monitor and rebalance periodically to keep the same risk profile.

The harsh reality is, being under or over-invested in different asset classes at the wrong time can have a significant impact on an investor's return. Getting market timing right is an extremely difficult task that can often leave investable funds on the sidelines during periods of strong returns.

History has shown that allowing emotions to drive investment decisions - be it overconfidence in rising markets or fear in falling markets - rarely serves investors well; and that over the long term, investors have traditionally been rewarded for showing patience and discipline around their investment strategy and diligence in rebalancing portfolios back to target asset allocations.

No one can be certain of what sort of volatility to expect from markets. However, we do know that previous periods of excess volatility have clustered around global macro events; and that during those periods, well-diversified portfolios that included allocations to less risky assets such as fixed interest and/or cash tended to ride out the storm much more smoothly.

So, while times like these can be unsettling for investors, those who have determined an appropriate asset allocation and who rebalance as necessary, are in a better position to weather periods of uncertainty, as well as the inevitable market dislocations to come.

The ASX ETF course has seven modules covering the fundamentals of what ETFs are and how to buy and sell them. Subsequent modules take a detailed look at particular types of ETFs, including a case study.

The modules are self-directed, meaning you can work through them sequentially or go from, say, domestic ETFs to international ETFs or exchange-traded commodities (ETCs). Each has summary slides and a quiz to help you be confident you have grasped the concepts.

Best of all, you can do the online course when and where you like, at your own pace, and print the notes. All you need is an internet connection and computer.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.